Mean-Variance Analysis

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DEFINITION of 'Mean-Variance Analysis'

The process of weighing risk (variance) against expected return. By looking at the expected return and variance of an asset, investors attempt to make more efficient investment choices- seeking the lowest variance for a given expected return, or seeking the highest expected return for a given variance level.

Mean variance analysis is a component of modern portfolio theory, which assumes investors make rational decisions, and that for increased risk they expect a higher return. 

INVESTOPEDIA EXPLAINS 'Mean-Variance Analysis'

There are two major factors in mean variance analysis: variance and expected return. 

  • Variance represents how spread out the data set numbers are, such as the variability in daily or weekly returns of an individual security.
  • The expected return is a subjective probability assessment on the return of the stock. 

If two investments have the same expected return, but one has a lower variance, the one with the lower variance is the better choice.

By combining stocks with different variances and expected returns in a portfolio (diversification), the variance and expected return of the portfolio can be altered as the price moves of one stock may be offset by the price moves of another in the portfolio. 

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